Like the article says, it's very hard to distinguish between market making and prop trading. Especially in illiquid stuff like corporate bonds, the MM needs to hold positions for extended durations, so they have a valid excuse to not be closed down entirely by Volcker.
The real reason they make all that money is flow. The guy on a desk like that knows what customers are calling, what they're concerned about, roughly how easy it is to get rid of stuff, and so on. It's not surprising he has a good idea of what's going to happen, and he's in a good position to take advantage.
Surprised their VAR (which is a crap way to measure risk) is not even halved in relation to before the crisis. People were definitely chucking it about back then, and the mood these days is like a morgue.
Market making is inherently prop trading - the firm's capital is at risk - unless trades are paired or hedged immediately. For thinly traded stuff that may take a while to unload, it is just prop trading.
I personally think Banks should be incredibly boring utilities. But that ship sailed a long time ago.
Lots of great stuff was thrown out the window in January. My winning bet for the year was to start buying EWC (ishares Canada) during the market lows.
You say "and the mood these days is like a morgue". Please elaborate.
If you prevent banks from doing the riskier forms of market making, then that responsibility will move to firms that don't have access to customer deposits.
Because their capital base is less stable, they will be more prone to stop making markets precisely when you need them most. That will probably make extreme volatility events like flash crashes much more likely.
'In the new system, the market makers are computers, and when things get hairy they just stop buying pounds and walk away with their computer hands in their computer pockets, whistling a jaunty tune out of their computer speakers.'
There is always a market for your asset. You might not like the price. Market makers that are not tied to TBTF banks would actually be more responsible because there is no safety net.
Aggressive traders who understand market structure can and will profit.
I remember flash crash days - my trading platform stopped responding - I could not get quotes and I could not do trades. I desperately wanted get a fill at the flash sale prices. No dice for me. Some friends who had stops in place found out that their broker had automatically sold their positions at deep discounts. Aggressive traders (with working platforms) benefitted for sure.
which platform was that? I am on IB & schwab. I've noticed on high volume days the Schwab desktop platform is not as available. Plus, Schwab has no up/down status page. Interactive Brokers has been more available & has the up/down status.
Volatility can be highly valuable in the long term to keep markets honest. Without that there is a tendency to add leverage until something far more significant breaks down.
The S&P 500 erased all losses within a week, but selling soon took over again and the indices reached lower depths within two weeks.
So, arguably the rebound is what was odd not the dip. There is a bias when looking at stock markets that says up is good and down is bad. However, accuracy is vastly i more important for the overall economy.
The mood among bank staff... everything is shut down by compliance, and if they could, they'd work in a different industry. People I know at banks, anyway.
Imagine tons of meetings about new/impending regulations that are unclear, poorly defined, restrictive, and enforced by regulatory employees who don't always understand the nuances of the businesses they are overseeing.
Imagine your compliance officer coming over to you or a coworker to give you news of an investigation of trading activity that happened months ago.
Imagine banks hiring compliance employees to keep up with a growing number of regulations, and firing IT guys to pay for it.
Imagine being quoted on the biggest trade of the year by a client who is screaming at your salesman for a price, and having to mentally iterate through a checklist of "is this over X dollars notional, does it surpass Y position limit, etc" because you have been in ten different meetings where compliance officers passed out Powerpoint presentations outlining new rules.
Imagine seeing an opportunity for a great trade, but doing nothing about it because you can't justify opening a new position in a subsector where you have no client positions.
Imagine having your emails and messages frequently investigated by regulatory bodies because they were flagged by a word search or some other unsophisticated screening tool, and being asked to write an explanation of months-old conversations that you have since forgotten. After a while, you don't feel comfortable putting anything in writing at all, even if you follow every rule in the book.
But you live in an expensive place and pay a lot of tax.
Plus the politics in a shrinking industry, you need a big premium to suffer through it.
A lot of people who work in banks do not have a particular love of the industry, they're there because it's what paid well when they finished university.
You could maybe convincingly argue that most market making is somewhat prop in nature, but surely not every prop trade is even remotely anywhere close to market making. As such, you can distinguish them, and arguing that they're "inherently" the same or indistinguishable, say, for regulatory purposes, is disingenuous.
Would you mind explaining what prop trading is? I am not familiar with this term.
From what I know of market making however is that you match a buyer and a seller of an asset, correct?
If I do have this correct about market making. Are they playing ask buy spread? Whose best interests is the market maker supposed to look out for? The buyers? The seller? Some combination therein?
The currency booth at the airport is a market maker. I give them dollars, they give me euros. They don't make me stand around and wait for a European to complete the trade, though. (That would be more classified as an exchange.) They are always willing to buy or sell at some price. The currency desk is mostly looking out for their own interest, but when I step off the plane, I want somebdoy to be there to sell me euros.
When George Soros decides to sell a billion British pounds, that's a prop trade. He's not hanging out letting the trades come to him.
(I say currency booth, not exchange, just to avoid confusion. We usually say exchange, because that's what happens, but it's not an exchange in the market sense.)
Trading desks can make money in three basic ways:
1. Buy low, sell high.
2. Manufacture a product and sell it, taking a cut.
3. Take a view on where the price is going to go, then take a position accordingly.
1. is basically market making. You can either wait until you have a matching trade and take a cut (=exchange, broker). Then you're always flat (that is, you don't care where the price moves - you always get your cut). Or you can post bid and ask at which you are prepared to trade. When someone avails themselves of this, you then have a position, and the market might move against you. The spread compensates for that risk. Key here is to distinguish informed traders (that offload stuff on you before the price drops due to some news) from "dumb money", aka noise traders, that just want to buy or sell some stuff, but don't have information where the price will go. The latter make you money on average, the former might cost you.
2. That's basically manufacture of derivatives, say. You buy or sell an option, charge something on top of the computed price, and then trade underlyers against it to be flat, and at the end ideally realise that charge.
3. This is basically prop trading. If you put on the proper position, and your view turns out right, you make money, otherwise you lose. You need to be right more often than wrong :-) and quite some capital cushion to balance out the wins and the losses.
So, prop trading is characterised by you NOT being flat, i.e. you are exposed to market moves. As someone pointed out, when you are market maker, you are also exposed, but it's for short periods of time, and not the main goal. However, this does introduce some ambiguity.
Market making you provide a buy and a sell price and keep the spread for your "service".
Prop trading: you buy or sell based on a guess which way things will go and hold that position then exit at (you hope) a profit.
Normally the big book of banking says market makers "provide liquidity" which in my experience is enough to make most people in banking stop right there as providing liquidity is to them akin to passing bread to orphans.
Also, prop traders use the firms money to trade, they don't use client money. So the firm is responsible for the loss and gets the benefit of the profit.
Brokerages pass on trades to market makers. They don't promise a price, they just tell you which price is available through market makers, and when you decide to go ahead with a trade, they go on the market, and you hope that the price market makers were advertising earlier is still what they're offering when you come through. Brokerages make a profit by passing on your order and taking a percentage of your total sale, not by making a profit on the spread.
I just find that whenever anyone wants to justify a total waste of resources like some people using microwaves to shave a micro off to nickle and dime the world it always comes down to some guff about liquidity to defend it.
Surprised their VAR (which is a crap way to measure risk) is not even halved in relation to before the crisis. People were definitely chucking it about back then, and the mood these days is like a morgue.
If you get better at measuring risk, VAR can go up. For instance, if your models assume that asset classes act in an uncorrelated manner, then VAR may be very low. You improve the model to capture correlation, and VAR for the same exact assets goes up.
Net - they could have a much less riskier position, but improvements in their risk modeling might not reflect it in VAR.
VAR can be good in conjunction with other metrics, but it's pretty awful as a standalone because it doesn't measure the severity of very rare tail events.
Generally market makers (banks) try to end the day with a flat position, and hence a flat risk profile. However prop trading (usually hedge funds) take more risk (due long term views) and are not so concerned about flat positions.
Yeah but the money he made from this doesn't sound like flow, sounds like a large directional bet (similar to the london whale event, except this one happened to work)
He uses the flow to decide what bet to make. Flow is the knowledge that people are asking about buying or selling, and sometimes trading one way or another. By knowing this you skew your prices to bias in the direction you think things will go.
The real reason they make all that money is flow. The guy on a desk like that knows what customers are calling, what they're concerned about, roughly how easy it is to get rid of stuff, and so on. It's not surprising he has a good idea of what's going to happen, and he's in a good position to take advantage.
Surprised their VAR (which is a crap way to measure risk) is not even halved in relation to before the crisis. People were definitely chucking it about back then, and the mood these days is like a morgue.